Backdating probe had surprises for investigators

SEC team behind stock-options cases think abuses have been corrected

SAN FRANCISCO (MarketWatch) - For Marc Fagel's team of government investigators, what began as an accounting and stock market puzzle turned into a major fraud probe that they believe has lifted the veil on the tech industry's shadier side.

Fagel has led a team of about 30 attorneys, accountants and paralegals with the U.S. Securities and Exchange Commission office in San Francisco, who have combed through millions of e-mails and conducted dozens of interviews in a stock-options backdating scandal.

Their work is now seen as having shed more light on how many tech companies manipulated stock-option grants by filing false financial information and sometimes even doctoring or making up meeting minutes -- even as some other legal experts argue that the agency has overreached by mistaking record-keeping and administration glitches for fraud.

One of the investigation's first major cases ended this week when a federal judge in San Francisco sentenced ex-Brocade
BRCD, -0.08%
CEO Gregory Reyes to 21 months in prison and ordered him to pay a $15 million fine. See full story.

Reyes is the first CEO to be sentenced to jail time for his role in stock-options backdating. Several other executives have struck plea agreements and paid hefty civil fines.

In an interview last month, Fagel's team talked at length about the investigation, which has led to legal action, including criminal indictments, against top executives from well-known tech firms such as Apple Inc.
AAPL, +1.63%
Juniper Networks Inc.
JNPR, -0.70%
and Broadcom Corp.
BRCM

Stock options give employees the right to buy shares in the future at the market price on the date a grant is approved. If the stock rises later, the recipient can cash in the option to take profit. Backdating a grant to a prior date when the price was lower increases the award's value. A company can legally do that, but the transactions have to be reported in public filings.

Fagel described stock-options backdating "just another fraud case," although he said the scandal also turned up some surprises for the agency. Members of the team, who have also worked with the U.S. Justice Department on backdating issues, declined to discuss specific cases or ongoing investigations.

Tipped by the press

When the issues first came up, Faglel said his team didn't exactly know what it was dealing with. The agency was alerted to the issue thanks to the work of academics, analysts and news organizations (particularly the Wall Street Journal, which first broke the story), who described how many companies appeared to be granting stock options at a time when their shares were trading low.

Fagel said the reports talked about "how unusually lucky a lot of companies seem be on the timing of their options grants."

At first, the agency thought the scam involved classic insider trading, which occurs when company executives make trades based on knowledge about their company that has not yet become public.

But Fagel said the SEC eventually came to "an increasing realization that the companies were in fact lying about the timing of the grants."

To prove their cases, the SEC combed through e-mails and documents and interviewed executives and rank-and-file employees at the various companies involved.

A critical part of the scam, said Cary Robnett, the SEC's assistant regional director in San Francisco, was doctoring minutes of meetings to change the date of stock options grants.

"For me, the practice of a lot of people involved in creating bogus minutes, high level people, shocks me," she said.

The SEC team also relied on so-called V-charts, which they prepared to get a visual idea of when stock options were granted in relation to the company's stock. Options granted at the bottom of the "V" -- where the stock was at a low point before shooting up -- typically triggered more suspicions that the company was doing something wrong.

"You see a dramatic picture," said Sheila O'Callaghan, a branch chief with the enforcement arm of the SEC's San Francisco office. "The stock prices were telling us a story."

Surprised by lawyer involvement

The SEC and other agencies have, so far, filed complaints against 10 chief financial officers, nine CEOS and eight attorneys, according to Robnett. The involvement of attorneys caused the most surprise for the team.

"One striking thing is how many lawyers have been sued and how critical a role that lawyers were playing in this fraud," said Michael Dicke, assistant regional director for enforcement at the SEC's office in San Francisco.

These lawyers, who were often the top-ranking legal experts at their respective companies, "had the necessary knowledge that what they were doing was wrong, and they were doing these things. That's surprising and disturbing," Dicke said.

Fagel said many corporate attorneys were "critical to the backdating process" and were "involved in very complex decisions about stock-option grants and what they mean for the company's financial statements."

The most prominent corporate attorney accused of playing a lead role in the options backdating scandal was Nancy Heinen, the former general counsel of Apple Inc. She was accused of filing false paperwork, including bogus board meeting minutes, in connection with an options grant to CEO Steve Jobs.

In a January 2001 e-mail to Jobs, she purportedly suggested a specific date for his options grant, saying, "To avoid any perception that the board was acting inappropriately for insiders prior to Macworld announcements, I suggest we use Jan. 10, the day after your Macworld keynote, at $16.35. That was one of the lowest closes of the month."

"It was somewhat surprising that a general counsel for a large corporation -- a previously respected general counsel -- would do the things that we believe she did," Dicke said.

Heinen has denied the charges and is fighting the case.

"Everything that Nancy Heinen did was fully transparent to the board and to the finance team, and she didn't deceive anybody," said her attorney, Miles Ehrlich.

"The accounting judgment made by Apple's accounting team ... was absolutely reasonable and defensible under the accounting literature that existed at the time," said Ehrlich, who previously served as a prosecutor for 11 years and was chief of the white-collar crime section of the U.S. Attorney's Office in San Francisco.

"Unfortunately, the SEC got this case wrong," he said. "It simply is not a case of backdating. In the Apple case, there was no 'there' there."

Attorneys for Lisa Berry, another lawyer accused of fraud in connection with options backdating, have also questioned the legal basis of the SEC's allegations.

Berry served as general counsel for KLA-Tencor Corp.
KLAC, -2.08%
and Juniper, and she allegedly played a critical role in options backdating schemes at both tech companies.

The SEC says that -- in an apparent sign of how options backdating became almost standard practice in some companies -- Berry even left instructions with employees in the company's human resources department prior to her leaving KLA-Tencor on how to "carry on with the scheme after she had departed."

Berry has denied the charges. In a motion filed in November asking a federal judge in San Jose, Calif., to dismiss the complaint, her attorneys argued that the agency "has dramatically and impermissibly overreached in bringing this motion."

Berry's attorneys have also argued that "companies can use an historical measurement date without taking a compensation charge in a variety of circumstances that do not result in a violation of law."

Charges still controversial

Other legal analysts have raised the same argument. Reacting to Reyes' sentence this week, Phillip Stern, an attorney with the Chicago law firm of Neal Gerber & Eisenberg, said he thought the punishment was too harsh, given serious questions on whether the ex-Brocade executive did anything illegal.

"I thought there were some very serious issues raised by the defense in terms of what Reyes' understanding was of very complicated accounting rules," he said. "These are very difficult cases to prove because of the complexity of the accounting involved."

Reyes' attorney, Richard Marmaro, has appealed the sentence. He also argued that Reyes "reasonably and justifiably relied on the professional accountants in the Finance Dept. within the company" to account properly for Brocade's stock-options policies.

"I think it is unfortunate that the SEC has chosen to use its resources to destroy the professional careers of individuals, many of whom were the founders and responsible for building great companies, based upon a technical accounting opinion that was widely misapplied by so many companies throughout the U.S. and did not impact the financial data that investors really care about: revenues and cash expenses," he said.

Fagel's team said that some companies, particularly their human resources departments, backdated options and neglected to record the change because it was not clear to them that had to be done. In fact, some companies came forward and restated their earnings based on these types of errors.

But Fagel stressed that his team only went after executives who clearly knew the rules but still went ahead and violated them.

"Nobody has an interest in bringing 200 cases against low-level HR people who were inputting bad information into the system," he said. "You want to find out: Was management involved?"

Dicke compared the legal challenge they faced to the case of baseball star Barry Bonds, who has been accused of lying to a grand jury about whether he knowingly used illegal performance-enhancing drugs.

"They have to prove that he knowingly made false statements," he said. "How do you prove that? That's a tough thing, and that's what we face in all our cases. We've got to usually prove some level of knowledge."

In fact, Berry's legal team has argued that the SEC has not "adequately alleged" her "scienter," a legal term that refers to an accused person's mental state in committing an offense.

Fagel said that many accused executives also typically claim that they were simply not aware of the legal requirements related to stock-option grants.

"The first line of defense from the people we have sued, especially the non-accountants, was, 'I'm not an accountant. I don't know anything about this,'" Fagel said. "But we do have evidence that they were aware of the issues."

Other accused executives also argued that they didn't personally benefit from the options grants, which companies have used mainly to attract and keep the best engineers and managers in a highly competitive industry.

To this, Fagel countered that executives benefited "because they own a lot of stock and the stock goes well as long as they don't come forward with the bad information. And they get to keep their jobs by meeting Wall Street's expectations."

David Larcker, an accounting professor at the Stanford Graduate School of Business, said the accounting principles and rules involved in the options backdating issue were clear.

"It's not like this is some kind of obscure accounting standard," he said. "They must have thought that the chances of getting caught were zero. For some of these companies, it must be hubris."

Some corporate-governance advocates said the federal probes of the options backdating scandal should help prevent the practice from being repeated.

"The SEC proceeded solidly and deliberately and carefully," Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, said after Reyes was sentenced. "The fact that you have a conviction here is pretty significant."

But Fagel said he believed stock-options backdating has now become an outdated scheme with tougher reporting regulations for corporations.

"A lot of the misconduct is going to be avoided in the future because of Sarbanes-Oxley," he said. "To some extent, we are cleaning up some past misconduct rather than have concerns about future misconduct in this area. My view is it's pretty unlikely that a company is going to be backdating stock options going forward, given both the changes in the law and the scrutiny that's been given to this area."

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